Thursday, February 22, 2007

Chasing yields: Closed end municipal bond funds

I’ve written about this elsewhere, but if you have already seen Sam Zell’s 2005 Year Eng Gift musical card, you should take a look [Follow the link for 2005 but be sure to check out the others such as 1999. It’s a blast!] It goes like, “Capital is falling on my head…” to the tune of “Rain drops falling on my head…” Mr. Zell is, of course, the Chairman of Equity Office Properties that was very recently the object of a bidding war between the Blackstone group and Vornado. Should he happen to look back upon his own creation just over one year ago he would surely be smiling at its prescience. At the same time, we must keep this in the back of our minds, if one of the smartest real estate investors is selling, what does it say about valuations?

The central theme of that particular musical card was that abundant capital had been driving down yields at a time the Western world is rapidly aging [and relying on fixed income securities to sustain retirement]. Over the past year, the spreads of riskier corporate and emerging market debt continued to narrow, in no small part driven by the Yen carry trade and other central bank inflationary policies. However, if forced to make an up-down prediction, I would have to bet that yields will continue its southerly trajectory, at least in the intermediate term. My reasoning is again based on the weak housing sector, especially rapidly catering subprime mortgage lending business. Therefore, it’s prudent to examine income generating securities, especially those providing high yields with good risk profiles. This very motivation was behind my recent purchase of CanRoys and NAT.

So that’s a rather long winded introduction to what I hope a multi part series on high yielding closed end funds. This post will deal with closed end municipal bond funds.

Closed end funds
Closed end funds trade on stock exchanges just like ETFs. The main difference is that ETFs are continuously offered such that their prices track the net asset values (NAV) closely. On the other hand, closed end funds have an initial offering where the number of shares is fixed and the price can deviate from NAV to a much greater extent. Double digit percentage premium/discount is not uncommon.

Municipal bonds and asset allocation
Municipal bonds are extremely tax efficient. The interest is exempt from Federal income taxes, as well as state income taxes in the state they’re issued. Interest from bonds issued by the local government is exempt form local taxes also. In one of my articles on asset allocation, I briefly mentioned the prevailing notion of putting bond investments in non-taxable/tax deferred accounts and equity investments in taxable accounts. An alternate strategy for high-income individuals is to put equities in tax deferred accounts and use municipal bonds as the bond allocation.

My own asset allocation
Real life financial arrangements rarely permit themselves for unambiguous delineation of bonds and equities (monthly review of my detailed holdings). When I got married, my wife and I each had our own 401(k)’s and individual accounts that we decided to keep in addition to starting a joint account. Today each of our 401(k)’s is under its own asset allocation plan. The joint account, which is a taxable account at Scottrade, is used to “plug the holes” in the overall asset allocation. For a while we had AGG, SHY and a foreign bond mutual fund in the taxable account which was about the worst thing one can do tax-wise. I chalk it up to my own procrastination. A couple of weeks ago I finally switched them to closed end muni bond funds NMO and NAD which I’ll describe in more detail below.

Closed end municipal bond funds
ETFConnect is a great site to do research on closed end and exchange traded funds. It is owned by Nuveen which happens to be one of the biggest muni bond fund managers.

Muni bond funds can be broadly divided into two categories depending on which municipality issued the bonds. There are state funds that are composed solely of bonds issued from one state. Then there are national funds that include all bonds issued in the US. Dividends from both kinds of funds are exempt from federal taxes because they are derived from muni bond interest. State funds make sense for those large states with high state income tax rates, such as California and New York. Funds for smaller states may have too low a trading volume and too wide a bid/ask spread. Residents in those states or in ones with low state income tax should consider a national fund instead. At year end, the fund manager will provide a breakdown of income attributable to each state; the amount from one’s own state is still exempt from state taxes.

Below is a screen shot of several national muni bond funds managed by Nuveen in descending order of yield.

It can be seen that a tax-free yield of 5.2% or above is easily achievable with these closed end muni bond funds. Assume a total marginal tax rate of 35%, they correspond to around 8% in taxable yield. Not too shabby! Astute readers may ask how these yields are possible when, for example, Vanguard’s long term muni bond funds yield only 4%. The answer is: leverage. These closed end funds issue short term preferred shares for approximately 1/3 of the fund’s assets at a lower yield. These shares are commonly purchased by tax-exempt money market funds. The holders of common shares are able to get quite a bit more yield by accepting greater risk. Putting some rough numbers together:

Preferred shares: 1/3 of assets, yielding 3.45% Common shares: 2/3 of assets, yielding 5.1% Total assets yielding 4.55% = 3.45%/3 + 5.1% *2/3

All payments are tax-exempt since they are derived from the pool of tax-free muni bonds. This is just a crude example. See Nuveen’s explanation and comments on volatility and hedging.

Other things to watch for
Yield is not the only factor based on which one should make purchase decisions. The principle “you get what you pay for” rings ever true here.

As mentioned earlier, the price of a closed end fund can deviate significantly from the NAV, depending on how enamored investors are with it. I personally have a hard time buying a bond fund with a premium over 5%.
Credit quality
Credit quality is very important especially when the fund is leveraged. I limit myself to average quality of AA or better. The extra 20-30 basis points for NMZ (average BBB rated and 10.2% premium) are not worth it in my opinion. In any credit event, the spread between high and low grade bonds will widen.
There aren’t a lot of variations in the table above. The average maturity is in the neighborhood of 20 years, with the duration around 5 years. A duration of 5 years means for each 1% change in the interest rate the bond price will change by 5%. Choices for shorter duration closed end bonds are more limited.
Certain muni bond interest is taxable under the alternative minimum tax (AMT). The percentage of AMT bonds is listed on the details page.

The volume in these closed end funds are only tens of thousands per day in the best case. So access to level II quotes is important for a good fill. Failing that, limit orders should always be used.

So how do these funds compare with the much better known treasury ETFs: SHY, IEF and TLT? Here’s a comparison chart.

The AAA rated NMO appears slightly more volatile than TLT, the long bond ETF. It makes sense because of NMO’s long maturity and use of leverage. Of course, NMO yields a tax free 5.2% compared with TLT’s taxable 4.6%. I ended up picking NMO and NAD for my own accounts, your mileage may vary. But if you have bond funds in taxable accounts or simply want a bigger kick than CDs and savings accounts, these closed end muni bond funds are definitely worth a look at.

Disclaimer: I’m not a registered investment advisor or a tax professional. The information provided above is believed to be correct but its accuracy cannot be guaranteed. You should consult a professional before making any financial decisions.